Learn how to become an investor – not a spectator

Learning how to become an investor is a critical step to financial freedom. But when you’re unsure of something, it’s easier to watch from the sidelines.

For example, variations of this phrase are uttered by people everywhere every day: “I think a correction is coming, so I’m staying out of the market for now.”

But there are (at least) two things wrong with this statement…

First: Yes, there definitely is a correction coming. But there’s a good chance you’ll be wrong about when markets are going to fall (unless, like a stopped clock, you happen to be coincidentally correct). Even investing legend Jim Rogers admits he made mistakes trying to time the market. And sometimes markets give you a bloody nose with a quick 5 or 10 percent slip, but then find their footing again. For most investors, trying to time the market is usually an expensive effort that’s doomed to fail.

Second: You’ll lose out far more by not being at least partly invested than you will with misguided, emotion-fueled attempts to time the market. That’s because stock market returns are extremely concentrated. Blink, and you’ll miss an entire generation of gains. That’s why “I think a correction is coming, so I’m staying out of the market for now” are words that can carry enormous opportunity cost.

So if you want to learn how to become an investor – and not a spectator – take note:

Here’s what happens when you miss the best weeks …

We looked at the weekly performance of the MSCI Asia ex Japan Index over the past 15 years. Then we looked at how performance over that period would change if an investor was not invested during weeks when the market performed best.

Since May 2002, the MSCI Asia ex Japan Index has had 783 trading weeks. Over that time period, it’s returned 299 percent (in U.S. dollar terms, including dividends), for an average annual return of 9.6 percent.

The table below shows what would have happened to that performance if an investor missed some of the best-performing weeks of the index. The single best five-day period for the index since May 2002 was the week ending October 31, 2008, when it rose 13.6 percent. If you had been invested for the other 782 weeks since May 2002, but missed that one specific week, your overall returns over the entire period would have fallen from 299 percent to 251 percent. Your average annual return over the 15-year period would have declined nearly a percentage point, to 8.7 percent.

That’s just the start, though. If you had missed the best-performing three weeks of the 15-year period, your total return would have fallen by 112 percentage points to 187 percent. Missed the best 10 weeks? You’d have made only 58 percent during the period, for an average annual return of just 3.1 percent. And missed the best 20 weeks? You would have lost money – nearly 10 percent – over the 15-year period.

The magic of compounding

The key here is that by missing out on relatively few weeks of great performance, you don’t just miss out on the returns of those great weeks. Your portfolio misses out on the magic of compounding. (If you really want to learn how to become an investor make sure you read up on compounding here). The return you didn’t earn that super week was not available to earn you an additional return in the following weeks and years that you were investing – because you didn’t make anything in that critical week.

That’s why the total return at the end of the period, 251 percent, would be so much less than the 299 percent return you’d have made if you’d been invested during the best-performing week of the index.

So is the answer to stay invested all the time? No. No matter how long your time horizon, the periodic serious corrections in stock markets will – like missing out on the good weeks – destroy your performance.

But you can exercise smart risk management by watching your stop loss levels carefully. Yes, you might miss out on some of the best weeks. But by missing out on a bigger correction, you’ll have done your returns a far bigger favour.

What else can you do? You can be in the market but still have a cash cushion. As we’ve written before, cash is the best hedge. It’s cheap and it represents potential… there’s nothing worse than seeing great investment opportunities and not having the cash to invest in them. Plus, when markets drop, the purchasing power of cash rises.

So don’t pull out of the market altogether because you’re worried that there might be a correction. If you want to learn to become an investor – and not a spectator – make smart use of trailing stops… and keep some cash in the bank for a rainy day.

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